What happened?

Volatility is a normal part of market behaviour. However, the hypervolatility experienced during 2008 was exceptional. Markets were taken down by some extraordinary events. For Canadian investors, the housing crisis in the U.S. and the “freezing” of world credit markets, combined with a slowing U.S. economy and falling resource prices, created an extremely difficult market environment.

The leveraging used by hedge funds and other professional investors greatly exacerbated the turbulence. As share prices fell, they were forced to sell quality assets along with their speculative holdings in order to pay investors who were redeeming their units and leaving the market. All of these pressures led to market volatility that was more than twice as great as historical averages.

Some of these factors were shortterm and will soon pass into memory. However, others are more fundamental.

For example, the U.S. economic weakness will continue to affect Canada significantly in the months ahead, as a result of slower trade with the U.S., falling retail sales, and a softening housing market.

What’s next?

U.S. weakness is likely to mean further slowing of the global economy as well. Economic growth is expected to falter in the high-flying BRIC countries (Brazil, Russia, India, and China). However, even with a slowdown from its previous double-digit growth rate, China’s GDP
may still rise 8% in 2009, enough to maintain its role as a driver of the world economy.

Market history

The good news for investors is that periods of market turmoil are rarely long-lived. History has shown that the markets tend to come back, often stronger than before. For example, after falling 20.2% from more than 4,000 in July 1987 down to 3,191 in the October 1987 Black Monday sell-off, the then TSE 300 Composite Index (now the S&P/TSX) came back by rising 25.4% in less than two years to close above 4,000 in August 1989. And following the technology crash of 2001-2002, the S&P/TSX Composite Index rose 57.9% — from less than 5,700 — to 9,000 in just over two years.

Investors with diversified holdings and sound portfolio management principles can come through these periods in a good position to make healthy gains as the markets resume their normal upward course.

Steering your portfolio

Here are some considerations to help you put the recent market volatility into perspective and plan your investment strategy for 2009.

•  Take a long-term view. Investing for the long term is the best way to limit damage from short-term market volatility. Over extended periods of time, market corrections become relatively insignificant dips in a long, upward price rise (see chart).
• Diversify your holdings. Holding a targeted mix of stocks, bonds, and cash allows you to participate when the market is rising, yet protects your capital during periods of volatility. Diversifying your holdings by sector and country can also help spread the risk.
• Rebalance your portfolio. To stay diversified and limit risk, it’s important to rebalance your assets when significant market moves cause your asset mix to stray from your targets. For example, if you’re a longterm growth investor with 70% of your portfolio in equities and 30% in bonds, a drop in the stock market may bring your equity allocation below its target weight. As part of a disciplined periodic rebalancing program, you might consider selling your “excess” bonds and reinvesting the money in stocks, to bring your asset allocation back on target. This would allow you to lock in any gains on the bonds and take advantage of new growth opportunities.
• Focus on fundamentals. Much of the activity during the 2008 sell-off was due to the unwinding of leveraged positions, rather than fundamental weakness in the companies being sold. This has created opportunities to invest in high-quality companies at reduced valuations. Taking advantage of these opportunities can create long-term value as the stocks recover over time.
• Keep a defensive core. During times of market volatility, it’s often wise to remain defensive in existing portfolios, holding quality stocks in less economically sensitive sectors such as gold, utilities, and consumer staples. These can produce steady long-term gains and help you weather volatility. When markets are down, consider enhancing this core with selected stocks in sectors that have been oversold.
• Don’t invest on emotion. In investing, emotion is your enemy. When trading is volatile, focus on maintaining your strategy rather than selling into falling markets. In these times, the winners are usually not those who sell their positions, but those who buy them for the long term.

The troubles in the U.S. financial system may take months to work out. We’re here to answer your questions and review your portfolio at every step of the way.

Staying disciplined and focusing on your longer-term goals can be trying during times like these. If you have questions about the current market conditions and how they may affect your portfolio, please do not hesitate to contact us.